While Delaware Statutory Trusts (DSTs) are passive investments that enhance diversification and provide tax-deferral benefits to investors, their restrictive nature creates certain limitations on a few aspects of operations. In this article, Realized 1031 focuses on DST leases and why the trust itself has little to no control over renewals and re-tenanting.
This guide will help you understand why such restrictions exist and what you can do as a beneficial interest owner. Keep reading to learn more!
The main reason DSTs face limited leasing capabilities is that they need to preserve 1031 exchange eligibility. In order to maintain capital gains tax deferral, DSTs must follow the structures and other requirements set by Revenue Ruling 2004-86. Otherwise, they will lose their status, and investors will become liable for the deferred taxes.
Under Revenue Ruling 2004-86, DSTs must maintain their nature as passive investments. Activities like the following can constitute “active management,” violating the rule:
In our discussion, the first two restrictions are the most relevant. The DST cannot commit to a new lease, nor can it modify an existing one. These limitations present one major problem: if a tenant leaves or a lease expires, the DST’s hands are tied.
DSTs typically include lease renewal options built into the master lease or tenant lease before the DST is formed. In general, these terms are pre-set, allowing the DST to avoid managing the property through negotiations for new terms. This structure provides predictability while maintaining compliance, but it also exposes the DST to expiration risk if a tenant chooses not to renew.
If the tenant does leave, re-tenanting can be even more complicated. The DST cannot seek new tenants or create new leases, as these are considered active management practices.
The main strategy is to engage with a master tenant, another party that handles the day-to-day operations of the underlying asset. The master tenant has the power to sublease the property and handle interim vacancy risk. If the underlying tenant leaves, the master tenant may continue paying rent to the DST under the master lease while it seeks a new subtenant.
Engaging with a master tenant is one of the few workarounds that DSTs employ to address lease-related risk. However, the most effective strategy is to lower renewal risk in the first place through structures like a triple net lease. Having long-term tenants through such arrangements ensures stability throughout the DST’s life.
Built-in renewal options, as we mentioned, also provide a way to get around the restrictions. Finally, entering a lease agreement with creditworthy tenants helps reduce the risk of tenant defaults and vacancies.
The nature of DSTs limits how much they can do when it comes to lease renewals and re-tenanting. There are strategies available, but they can be restrictive. That’s why, for investors, due diligence during DST and sponsor selection is critical before entering the investment. The right DST structure anticipates these operational boundaries, so that when renewal or re-tenanting decisions arise, investors can expect stability instead of surprises.
Sources:
https://www.investopedia.com/terms/t/triple-net-lease-nnn.asp